Apple: An Options Strategy Surrounding Earnings

Let me start off by stating that this article is directed toward the long-term ( one year time horizon) Apple (NASDAQ:AAPL) investor, not the “trader.” I have authored other articles that discuss my aversion to “trading” options. I prefer to use option strategies as a method to reduce risk not for “one-off” trades. That said; let’s look at the peculiarities currently surrounding Apple.

AAPL is scheduled to announce earnings on January 17, 2012. It would be fair to say that everyone in the world is expecting “blow out” earnings for a variety of reasons (including, but not limited to the iPhone delayed launch). This presents a real problem for investors. How much is expected, how much would exceed and how much would disappoint? AAPL could show enormous earnings but the stock could suffer.

This is further complicated by the likelihood of “traders” buying pre-announcement and selling after the announcement. So, even if AAPL spikes up, it may be followed with a decline. This could be exacerbated as the monthly options expire just a few days after the announcement. That means that “traders” who bought calls, are likely to take profits and move on. If anything, the bears might come in and buy puts. These are some of the factors that will influence AAPL’s price and there’s no way of telling what will happen.

Now, for the “perma-AAPL-Bull” none of this matters. They are steadfast in their beliefs and that’s that. But, for many others, the impending announcement and the market reaction presents a quandary. If nothing else, they worry about it and maybe lose a little sleep.

Well, I think the appropriate option strategy can take a lot of the guesswork out and give the investor some more assurance. But first, we must make some assumptions regarding the stock’s prospects.

My first assumption is that AAPL will likely go up over the next year. How high depends upon environmental, economic, global and competitive forces in addition to the viability and timeliness of its new product releases. Given this level of uncertainty I think a move to $500 (25% up from here) would be a good estimate of the upside potential. Frankly, if it goes up 25% I’d be more happy than disappointed.

So, I’ll develop my strategy based upon a willingness to cap my gains at a $500 share price. I also want to protect my position if AAPL falls, but not limit myself if there is a big jump immediately after earnings. So, here’s how I will try and balance all these interests.

First, I will buy a January 2013 (please note this is a 2013 dated option, not 2012) Put at-the-money at $400 strike. This costs $57.20.

Next I will sell a January 2013 out-of-the-money put with a strike of $320. This credits $25.05.

So, if I look at this Bear-Put-Spread, my combined cost is $32.15 and I have protected my AAPPL position for a 20% decline (from $400 to $320). Of course, I could provide for greater decline protection by setting the strike for the OTM put lower.

Now, “normally” I would also sell a January 2013 out-of-the-money call with a strike of $500. This credits $20.70. This brings my combined cost for the three legs down to $4.35, or about 1% of AAPL’s price.

This would give me a range upward to $500 and protection down to $300.

I say, “normally” because earnings are near and there is an expectation of a “pop.” I certainly would want to see what happens before I place this upside constraint on my possible future appreciation.

So, instead, I will wait till the announcement before I sell the third leg - the OTM call. If AAPL jumps to, say $440 I could either sell the $540 call instead of the $500 call for approximately the same credit, or I could decide to stick with a $500 call and get an additional credit of approximately $15.

I suspect, in any event, that I would sell this call within a few days of the announcement and try to beat the “traders.” But this is a judgment call each investor must make.

If AAPL doesn’t “pop” but drops, instead, well there is the put that was purchased that will help offset the price decline. I’ll get a little less for selling the $500 call, but that’s the price of delaying till after the announcement. But I'm glad I bought the put.

Please keep in mind that this strategy is designed to address any uneasiness about AAPL with the upcoming announcement. But it also provides a full year of protection for all the other unforeseen events that could put pressure on the stock.

One must weigh the 1% cost and the maximum gain capped at $500/share against the uncertainty. Maybe, the investor could even increase the holding in AAPL once the protection is in place. After all, limit the risk and one need not be so timid.

One last thought. The call is a covered call and the put-spread is a debit, so no margin is used up for any leg (just the cash for the ATM put). Also, the investor could sell puts instead of owning the stock directly, just make sure that the put that will expire January 21, 2012, is sufficiently in-the-money to capture any possible gain (I would suggest at least a $450 strike).